Predicting Borrower Behavior For 2018

Loan Structures for 2018

In 2010, Paul the octopus was tasked with predicting the outcomes of the World Cup. At feeding time, Paul was presented with two different glass boxes that contained his food each representing one of the teams. To Paul’s credit, he was on a roll as he correctly predicted the outcome of all eight German soccer matches leading up to the final. However, instead of having abnormally strong psychic or predictive prowess, the little cephalopod was just lucky. There was a 1 in 256 chance that Paul would correctly divine the outcome of each German match, and he nailed it. As they say, it is very hard to make accurate predictions, especially about the future and bankers must be clear about the difference between an accurate forecast and luck. At CenterState, we are skeptical about predictions, especially when it comes to human behavior.  However, when it comes to interest rates, we do have an advantage as banks can look at forward curves, the shape of the yield curve and the Federal Reserve’s predictions to come to some poignant predictions for borrower behavior in 2018.


Bank Lending


The Current Environment


Currently, borrowers are favoring certain loan structures because of the shape of the yield curve. Borrowers are interested in longer-term fixed rate loans because the difference between five and ten-year fixed rates is small (15bps) and continues to shrink as shown in the graph below. That delta is expected to go to zero in 2018.


Flattening Yield Curve


The quote sheet below shows that the current monthly P&I difference between a five and ten-year $500k fixed rate loans is only $41.  The monthly P&I difference between a ten and a 15-year fixed rate is only $22. 


Fixed Rate Loan Pricing

 Predicted Behavior


With the Fed increasing short-term rates today by 25 bps and indicating another 75 to 100 bps increase in short-term rates next year, how would borrower behavior change in 2018?  The graph below shows where the Fed expects short-term rates to be through 2020. 


Implied Fed Funds


The rise in short-term rates, however, is not paralleled by the market’s expectation that long-term rates will rise in kind.  In fact, the market expects long-term rates (the ten to 20-year portion of the curve) to increase by nine to 15 bps through 2018. Our data shows that the average contractual commercial loan maturity at community banks has increased by 1.9 years from 2016 through 2017.  The extension of commercial loan maturities will continue in 2018 because the incremental cost of borrowing from 2-year fixed to 10-year fixed will contract sharply. 


The quote sheet below shows where the market expects the monthly P&I payments to be in December 2018 for two and ten-year $500k fixed rates. The monthly P&I difference across the entire yield curve will disappear, exerting pressure on commercial loan duration.  


Loan Pricing



As the yield curve flattens, community banks’ cost of funding will increase.  Average deposit betas for the industry were only 18% in 2017 (slightly higher for smaller banks). However, we believe that deposit betas will increase to an industry normal 50% in 2018 (see Lessons From The Last Rate Cycle HERE).  Banks will need to address rising cost of funding, increasing interest rate sensitivity and potentially lower net interest margin on their loan portfolios.




We anticipate that banks will continue to see more pressure to offer ten-year fixed rate commercial loans, and successful banks will identify ways of meeting that borrower demand. Furthermore, longer fixed rate commitments will help banks mitigate credit risk for the borrower. Banks that can differentiate their loan offering and can present borrowers with 15 or even 20-year fixed rate loans will be able to obtain not just superior credit quality, but higher risk-adjusted returns and higher cumulative lifetime customer value.


In typical national fashion, Paul the octopus lost his countrymen's affection once he forecast an unfavorable outcome, and Germans threatened to turn Paul into calamari. While we recognize we could be at risk for the same fate, we will continue to trust in the markets and historical borrower behavior to keep us out of the frying pan.